4/17/2009 @ 12:25PM

Did Greenspan Cause The Housing Bubble?

Critics across the political spectrum are having a field day blaming the current economic crisis on former Federal Reserve Chairman Alan Greenspan, who they allege carried out an excessively expansionary monetary policy following the recession of 2001. But a careful examination of his record shows little support for this view.

Greenspan, however unintentionally, came close to freezing the domestic monetary base. He therefore still stands out as the only truly successful chairman of the Fed, which, by the way, is one good reason among many for abolishing it. We simply can’t depend on his like coming to the fore again, as Ben Bernanke’s disastrous tenure is making clear.

Why do people now believe Greenspan was an “inflationist?” Mainly for one reason: they note the low interest rates from 2002 to 2004. But this ignores the simple fact that interest rates can change as a result of real factors involving supply and demand. As Greenspan, among others, has repeatedly (and again recently) demonstrated, these unusually low interest rates were due primarily to a massive flow of savings from emerging economies in Asia and elsewhere.

Although the broader measures of money have become an unfashionable way to gauge monetary policy, their behavior during the period of low interest rates should still make us skeptical of the idea that Greenspan had opened the floodgates. The annual year-to-year growth rate of money with zero maturity (MZM) actually fell from over 20% in 2001 to nearly 0% by 2006.

During that same time, growth of the M2 money supply (includes currency, checking accounts, time-related deposits, savings deposits and non-institutional money-market funds) fell from over 10% to around 2%, and M1 (currency plus checking accounts) growth fell from over 10% to negative rates. Admittedly, the Fed’s control over the broader monetary aggregates has become quite attenuated, for reasons elucidated below. But even the year-to-year annual growth rate of the monetary base, which the Federal Reserve directly controls, fell from 10% to below 5% between 2001 and 2006.

The real key to what was going on is revealed by the components of the monetary base. It consists of reserves held by the banks and other depositories, either in their accounts at the Fed or as vault cash, plus currency in circulation among the general public. Between December 1986, eight months before Greenspan became Fed chairman, and December 2005, nineteen years later, the monetary base rose from $248 billion to $802 billion (figures are not seasonally adjusted). True, that doesn’t sound like a freeze, but virtually the whole increase was in circulating currency.

During those same 19 years, total bank reserves (including all vault cash) grew from $65 billion to $73 billion, for an average annual growth rate of a mere 0.65%. In some years, aggregate reserves rose, in others they fell, with the major bump surrounding the year 2000. Total reserves are also the one monetary measure with growth showing a temporary uptick into 2003, when interest rates were down.

Currency in circulation exploded even faster than the base, at an annual rate of 7.54%. But most of this new cash went abroad, as a stable dollar became an international currency. These growing foreign holdings of Federal Reserve notes became an additional factor increasing money demand and keeping U.S. inflation in check during the 1990s. On the other hand, Greenspan’s virtual freezing of reserves is the most salient yet ignored feature of his tenure. After adjusting for currency going abroad, it means he approximated a de facto freezing of the domestic base.

Greenspan also helped deregulate the broader monetary aggregates: M2, MZM, and M3 (the broadest measure of money). The Depository Institutions Deregulation and Monetary Control Act of 1980 had begun phasing out interest-rate ceilings on deposits and modified reserve requirements in complex ways.

Combined with subsequent administrative deregulation under Greenspan through January 1994, these changes left all the financial liabilities that M2 adds to M1–savings deposits, small time deposits, money market deposit accounts, and retail money market mutual fund shares–utterly free of reserve requirements and allowed banks to sweep a large portion of M1 checking accounts into M2 money market deposit accounts. M2 and the broader measures became quasi-deregulated aggregates with no legal link to the size of the monetary base.

One result, which the late Milton Friedman noted in 2003, is that fluctuations in the velocity of M2 were automatically offset by fluctuations in the amount of M2. Interestingly, this is exactly what monetary economists George A. Selgin and Lawrence H. White predict would happen under free banking, that is, a market-determined monetary system without any government involvement.

They argue that free banking would automatically adjust the quantity of money to changes in velocity. If velocity rises, signaling a fall in money demand, market mechanisms would cause banks to reduce the quantity of money they created. And if velocity falls, signaling a rise in money demand, banks would enlarge the quantity of money.

Thus, during the dot-com boom of the ’90s, M2 velocity rose as people shifted into stocks. But this was perfectly offset by the declining growth rate of M2, which fell to near zero between 1994 and 1996. Assorted Fed-watchers reached opposite conclusions, depending on which variable they focused on.

Those who looked at M2 warned that Greenspan’s policies were deflationary, while those who looked at the higher growth rates of the base and M1 predicted higher inflation. Both were wide of the mark, but not because of Greenspan’s miraculous central-bank discretion; the result was a product of market process, and when the collapse of the dot-com boom burst the M2 velocity bubble, it induced a new spike in M2 growth.

If Greenspan almost froze total reserves, why, in a growing economy, wasn’t there deflation? The reason is the free market’s enormous capacity for innovation. Because bank reserves in the U.S. paid no interest until October of last year, banks had a strong incentive to economize on their use. Each dollar of reserves was standing behind more and more dollars of M2.

So what caused the current financial crisis? Economists will probably not know the full answer until many years from now. Minor blips in total reserves under Greenspan may have played some role. Because Greenspan only imperfectly implemented Milton Friedman’s proposal of freezing the monetary base, without intending to do so, his policy may have ended up slightly too discretionary. But that possibility hardly justifies the widespread claim that the Fed could have pricked or prevented the housing bubble.

Jeffrey Rogers Hummel is an associate professor of economics at San José State University and the author of Emancipating Slaves, Enslaving Free Men: A History of the American Civil War. David R. Henderson, a research fellow with the Hoover Institution and an associate professor of economics at the Naval Postgraduate School, is the editor of The Concise Encyclopedia of Economics (Liberty Fund, 2008).